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New Vehicle Dealership Audit Technique Guide 2004 - Chapter 7 - Extended Service Contracts and Aftermarket Products (12-2004)

NOTE: This guide is current through the publication date.  Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.

Each chapter in this Audit Techniques Guide (ATG) can be printed individually. Please follow the links at the beginning or end of this chapter to return to either the previous chapter or the Table of Contents or to proceed to the next chapter.

Chapter 6 | Table of Contents | Chapter 8

Chapter 7 - Table of Contents

Introduction
Extended Service Contracts
Credit Life Insurance; Credit Accident and Health Insurance
General ESC
Agent versus Principal/Obligor
Service Warranty Income Method (SWIM)
VSC Audit Technique Flow Chart

Introduction
The automotive dealership industry plans for products, tangible and intangible, that the consumer may add to the new vehicle during or after consummation of the sale. This "aftersale market" is substantial and includes, but is not limited to, products such as financing, wheels merchandise, extended service contracts and service.

This section focuses on the sale of Automobile Dealership Aftersale Market Products as they relate to the sale of new and used vehicles. Products sold primarily include extended service contracts, credit life insurance and credit accident and health insurance. Though references in this section concern new vehicles, these products have substantially similar application to used vehicles. At the end of this chapter are suggested audit techniques and a flow chart to assist the agent in identifying vehicle service contracts and maintenance contracts (VSC) issues. This is also to provide guidance to dealers and practitioners on the proper tax treatment of service contracts. A VSC audit technique flow chart is the last exhibit of this chapter as a visual aid.

Extended Service Contracts
Motor vehicle dealers sell extended service contracts (also known as mechanical breakdown contracts or multi-year service warranty contracts) for used cars and as a supplement to the standard manufacturers' warranty for new cars. The plans cover repairs for specified components, and may be purchased for a variety of terms and miles. The minimum term is usually 2 years and the maximum is usually 7 years, one manufacturer offers 10 years. The charge for the plan may be separately stated on the vehicle sales contract, or there may be a separate contract for the plan.

Regardless of what type of plan is sold, an administrator usually handles administrative functions and pays claims. In addition, the administrator determines the "cost" of the plan and provides a cost schedule to the dealers. Based on the cost schedule, dealers establish the selling price of the service contracts and retain a portion of the price as commission. The commission amount is usually reported as income in the year the contract is sold. Treatment of the remainder of the selling price varies depending on what type of plan is sold. Vehicle service contracts and maintenance contracts are a significant source of aftersale income. They can also be a significant source of confusion regarding the correct tax treatment of the programs.

Dealers may offer the contracts as principals or as sales agents of manufacturers, distributors, administrators, insurance companies, or another party. An agent is one who sells the product of a third party without assuming the legal obligations of the products sold. Typically, the agent receives a fee for the sale and necessary administrative services rendered. A principal is a party to the contract who assumes the risk of the contract provisions and is directly responsible for any ensuing liabilities. The principal derives compensation from the profit built into the cost of the product.

Dealers often offer more than one "brand" of service contracts with each contract offering different terms and conditions. The dealers may operate as the principal, also referred to as "obligor" on some contracts and as an agent on others.

When dealers act as sales agents, they retain a selling commission and remit the balance to the plan administrator. When dealers act as principals, they may purchase an insurance policy to cover their liability under the service plan. When the dealer is the principal and covers its risk by purchasing insurance, there are two transactions: one between the dealer and the customer, and the second between the dealer and an insurance company.

If the dealer does not purchase insurance, it may enter into an arrangement whereby a portion of the selling price is deposited into an "escrow" or "trust" account and a small portion of the price is used to purchase "stop-loss" or "excess loss" insurance.

Regardless of what type of service contract the dealer sells, the contracts are usually memorialized on documents provided by the administrator or promoter. The terms and conditions of each contract must be reviewed to determine whether the dealer is the agent or the principal.

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Credit Life Insurance; Credit Accident and Health Insurance
Many consumers who finance the purchase of a vehicle, purchase Credit Life Insurance and/or Credit Accident and Health Insurance (also known as Credit Life and Disability Insurance). If the buyer dies before the loan is paid off, Credit Life Insurance benefits pay off the remaining balance. Thus, Credit Life Insurance is decreasing term insurance.

Credit Accident and Health Insurance pays the buyer's monthly loan payment when the buyer is disabled, as defined in the insurance certificate, after a specified waiting period, if any. The payments continue as specified in the insurance policy, usually as long as the buyer is disabled.

States have regulations concerning the sale of credit life and disability insurance that are enforced by an insurance commissioner. These regulations may affect premiums, commissions, etc. and usually provide that the insurance must be sold through an insurance company that is authorized to sell this type of insurance in the state where the dealership is located.

Most dealerships sell both Credit Life and Disability Insurance in conjunction with the sale of vehicles and it is a significant source of income for the dealership. This income is usually in the form of commissions (up front) ranging from 30 to 50 percent. Some states place a cap on the commission percentage. The dealership may also receive income through retrospective agreements and/or reinsurance arrangements.

Retrospective Agreements
Retrospective arrangements are "back ended" and are programs designed to allow the dealer to participate in the profitability of the insurance business. Reinsurance programs are alternatives to commission caps imposed and regulated by many states. Reinsurance is the transfer of risk from the primary insurance company to the reinsurance company that may be established by the dealer. Reinsurance arrangements were first used by dealerships for their sales of Credit Life and Disability Insurance as a way to increase their commissions above the state cap. However, reinsurance arrangements are frequently used now in connection with VSC's.

General - ESC
Dealerships frequently offer extended service contracts to their customers in connection with the sale of a vehicle. Extended service contracts provide for repairs to covered vehicle components during a designated term. The term runs parallel to the manufacturer's warranty coverage and for an extended period beyond the manufacturer's warranty term. In other words, the customer is paying an additional amount for an extra two to seven years beyond the manufacturer's prescribed term.

The dealership often sells more than one type or brand of service contract and may be either, the "principal" / "obligor" or "agent." If the dealer is an agent of the administrator, insurer, or other party, the contract will contain language that indicates that the contract is between the vehicle purchaser and the other party, not the dealership. The contract administrator is also named in the contract.

If the dealer is the principal, the contract will contain provisions indicating that the contract is between the dealer and the vehicle purchaser. The contract would also contain language indicating the administrator and the party that insures that dealer's interest. In addition to the vehicle service contract, other documents are important to the extended service contract program. Other documents include an administrator agreement and an insurance policy.

Regardless of whether the dealer acts as an agent or the extended service contract is a dealer obligor plan, the administrator generally provides the vehicle service contract documents.

All contracts related to the service contract plan must be examined to determine whether a dealership is an agent or principal. Proper tax treatment of extended service contracts depends on an accurate determination of who is obligated under the contract. 

Role of Administrator
An administrator is usually an unrelated party. They are responsible for administering service contracts for the dealerships. A dealership could have agreements with several administrators to provide this service.

The administrator provides the dealership with "dealer cost schedules" which establish administrative fees to be remitted to the administrator for various contract terms and classes of vehicles. The fees may change from time to time by the administrators. The difference between the actual price paid by the customer and the amount remitted to the administrator is retained by the selling dealership. The actual sales price of service contracts is subject to negotiation between the dealership and the customer, and the prices varied accordingly. A portion of the amount paid to the administrators may be  used to purchase insurance related to service contract claims.

The purchaser (customer) is directed to return the vehicle to the dealer in the event of a mechanical breakdown. Repairs performed by another repair facility are not covered by the contract unless the purchaser secures the Administrator's prior authorization. When the Administrator authorizes covered repairs by another repair facility, the Administrator arranges for payment of the claim from a reserve fund on the dealer's behalf.

Agent versus Principal/Obligor
A dealer can market after-sale products as either an agent or as a principal. Dealers sometimes attempt to structure these transactions so they will be classified as agents due to the favorable tax treatment.

What an agent or principal/obligor is in the context of the sale of extended service contracts can be loosely defined as follows:

  1. Agent
    An agent is one who sells the products of a third party insurer without assuming the legal obligations or insurance risk of the product sold. The agent receives a fee for the sale and necessary administrative services rendered. The activities of an agent are not strictly limited to sales of insurance. In the past, some dealerships were selling factory extended "warranties" as agents for a product that was not then considered by the parties to be an "insurance" product. 

  2. Principal/Obligor
    A principal is a party to the contract who assumes the risk in the contract, is directly responsible for any ensuing liabilities that may arise and derives compensation from the profit built into the product sold. The principal in the automobile context will generally insure the obligations undertaken in these contracts with a third party insurer, but remains the primary obligor to the consumer.

As a principal/obligor, dealers should include in income the full amount received from the consumer for the mechanical breakdown contract. The amount remitted for the insurance premium should then be amortized over the term of the contract. 

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Dealer "Agent" Extended Service Contracts
If the extended service contract is between the vehicle purchaser and an administrator, insurance company or other party, the dealership acts as an agent and earns a commission. Generally, the dealership determines the selling price of the extended service contract and forwards a portion to the administrator based on a "cost schedule." The commission income must be accrued when the contract is sold. The commission amount is the difference between the extended service contract selling price and the amount the dealer forwards to the administrator, insurance company, or other party.  TAM 9218004 provides guidance on determining agent vs. principal and the proper tax treatment of the commission income.

Note: Private Letter Rulings (PLRs) AND Technical Advisory Memorandums (TAMs) are addressed only to the taxpayers who requested them. Field Service Advisory's (FSAs) are not binding on Examination or Appeals, nor are they final determinations. Furthermore, Section 6110(k)(3) provides that PLRs, TAMs and FSAs may not be used or cited as precedent.

Dealer "Obligor" Extended Service Contract

When the extended service contract is between the vehicle purchaser and the dealership, the dealership is the "obligor" or "principal" on the contract. When a dealership acts as obligor or principal, it may purchase an insurance policy that insures its liability under the service contract. Thus, there are two transactions: one between the dealer and the customer, and the second between the dealer and an insurance company.

  1. Issues: Dealer Agent and Dealer Obligor Programs
    All contracts related to the service contract plan indicate whether a dealership is an agent or principal/obligor. Proper tax treatment of extended service contracts is determined by whether the dealer is the agent or obligor.

    1. Dealer Agent programs

      1. Commissions must be included in income in the year the VSC is sold.

    2. Dealer Obligor programs

      1. Selling price of the VSC must be included in income in the year the VSC is sold. 

        • Service Warranty Income Method (SWIM) may be elected.

      2. Insurance premiums must be amortized over the term of the contract.

      3. Administrative fees can be pro-rated if the taxpayer can demonstrate a reasonable manner in which to estimate the amount (cost) and timing of services.
         

  2. Documents Needed

    1. Request a listing of all VSC/maintenance plans sold to the dealership during the year(s) under examination.

    2. For each program sold, request the following information:

      1. Copies of actual, executed vehicle service contracts

      2. Copies of any promotional material

      3. Copies of any and all agreements and documents including all endorsements, amendments, and schedules between the dealership and other parties to the program.

        • Documents may include but are not limited to: dealer agreements(s), administrator agreements(s), contractual liability insurance policy, service contract reimbursement insurance policy, consulting agreement(s), management agreements(s), reinsurance agreements(s), and warehouse agreements(s)

      4. Request that the dealership provide, in writing, samples of all accounting entries for all income and expenses.

    3. Request a written statement from the owner of the dealership concerning:

      • Payments made by any party to the program, directly or indirectly, to the dealership owner, any relative of the owner, or entity owned (all or in part) or controlled by the owner.

    4. Do not be afraid to ask questions about the dealership¡¦s programs.

      1. Do not limit questions to the dealer¡¦s representative, controller, or employees.

        • The dealer principal (dealer/owner/shareholder) may be the only one fully informed regarding the details of the programs.
           

  3. Audit Techniques

    1. Determine by review of the vehicle service contract language whether the VSC is dealer obligor or dealer agent.

      1. Generally, dealer obligor contracts state that the VSC is a contract between the vehicle purchaser and the dealership.

      2. Dealer agent contracts are typically between the vehicle purchaser and an administrator or insurance company.

      3. Dealer obligor contracts contain a provision naming an administrator and/or insurer and may contain terms similar to the following:

        • The agreement is not an insurance policy.

        • The dealer is financially responsible for all repairs under the VSC.

        • The dealer¡¦s obligations under the contract are insured by "Insurance Company" 

        • The administrator is not obligated under the contract.

    2. For dealer obligor contracts:

      1. Analyze the administrator agreement to determine the dealership and administrator¡¦s responsibilities under the program. (Note: Some dealerships participate in multiple programs that apply to the same VSC. For instance, one program provides basic program administration and claims handling while a second program simultaneously provides for the establishment of the dealership's PORC. As a result, the dealership may have multiple administrative agreements, insurance policies, etc. To determine the proper tax treatment on the sale of the VSC, the entire transaction must be analyzed.)

        • The administrator agreement may include a provision for a reserve or escrow account, the establishment of a PORC, payment of various fees to parties related to the dealership or administrator, etc.

      2. Review amendments, endorsements, and schedules for clues to other agreements, payments to related parties, etc.

      3. Analyze the insurance policy to determine the coverage and to determine the "name insured"

        • Generally, dealer obligor programs provide for a contractual liability policy naming the dealership as the insured.

        • Determine if there is any common ownership between the dealership and the insurance company.

        • Determine if the dealership or other party related to the dealership provides indemnification to the insurance company.

        • If the dealership purchased insurance from an unrelated insurance company and did not enter into a reinsurance agreement, determine if the selling price of the contract is included in the income in the year the contract is sold.

          • Determine if the cost of insurance was amortized over the contract life.

          • Determine if the dealership properly elected and applied the Service

          • Warranty Income Method (SWIM) of reporting income.

          • Determine how the dealership accounted for administration fees.
             

  4. Aftersale Market Products Issues and Authority

    1. Dealer Obligor Contracts-Insurance Purchased (No PORC involved)

      1. Include selling price of VSC in income in the year sold.

      2. Cost of insurance must be amortized over the life of the contract.

      3. SWIM (see below) allows the qualified advance payment amount (including a provision for interest) to be deferred provided that certain conditions are met including:

        1. SWIM must be properly elected and applied.

          • To properly elect SWIM, the dealership must purchase insurance from an unrelated party.

        2. Insurance premiums must be amortized.

      4. Administrative fees can be amortized if the taxpayer can demonstrate a reasonable manner in which to estimate the amount (cost and timing of administrative services. If not, a deduction should not be allowed until the end of a contract.

Dealerships that sell dealer obligor contracts and purchase insurance to cover their risks often report the income in a manner similar to a dealer agent contract, i.e. report only the commission income. To properly account for a dealer obligor contract, the dealership must include in income the entire sales price of the service contract.

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Income Issues:
Automobile Club v. Commissioner, 353 U.S. 180 (1957): Generally, taxpayers that determine their taxable income using the accrual method of accounting must include advance payments in income when received. The Supreme Court applied this rule Automobile Club v. Commissioner, to membership dues collected 1 year in advance. The rule was also applied to service contracts in Streight Radio and Television, Inc. v. Commissioner, 280 F.2d 883 (7th Cir. 1960) where the taxpayer had unrestricted use of the funds.

Rev. Proc. 71-21, 71-2 C.B. Page 549 provides for an election to defer advance payments for services where the services are to be performed by the end of the next tax year.

When a dealership is the principal on an extended service contract, the sales price of the service contract constitutes an advance payment and the dealership must include the full sales price in income when the contract is sold. The exception provided by Rev. Proc. 71-21 does not apply since the terms of the contracts are 2 years or more, and the services will not be performed by the end of the taxable year after the year of sale.

In Hinshaw's, Inc. v. Commissioner, T.C. Memo. 1994-327: The Tax Court specifically addressed this issue in the dealership context in two cases. In Hinshaw's, Inc. v. Commissioner, the Tax Court ruled that all amounts collected for extended service contracts were includable in income in the year received.

In Rameau Johnson, et al, v. Commissioner 108 T.C. 448 (1997), aff'd in part, rev'g in part, 184 F.3d 786 (8th Cir. 1999), the dealerships retained a portion of the contract price as profit and forwarded the remainder to the administrator for deposit in an escrow account, for payment of administration fees, and for the purchase of excess loss insurance. The escrow amounts earned investment income. Dealers received distributions from the escrow accounts, within certain limitations, for specified purposes such as compensation for covered repairs, cancellations, and the release of "unconsumed reserves" at the expiration of a contract. The dealerships included in current income the profit portion of the contract price but included the escrow amounts as they were released.

The Court ruled that when the dealership sold an extended service contract, it acquires a fixed right to receive, and must currently include in gross income, the portion of the contract price deposited in escrow.

The Court also ruled that the dealer is treated as the owner of the escrow account and must currently include investment income earned by the accounts in gross income of the dealership.

Amortization Issues:
Higginbotham-Bailey-Logan Co. v. Commissioner,
8 B.T.A. 566:
When dealers pay a premium to insure their liability under the service plan that they sell, the term of the insurance is the same as the term of the contracts. Insurance premiums for policies covering more than 1 year must be amortized ratably over the term of the policy. Taxpayers using the accrual method of accounting must prorate and deduct ratably over the term of the policy prepaid insurance premiums.

In Hinshaw's, Inc. above, the Tax Court specifically addressed amortization of insurance purchased to cover the dealer's risk under the extended service contract. The Court ruled that the dealership "* * *entered into contracts with its customers that required [it] to protect the customers from vehicle service costs for up to 7 years. [The dealership] then purchased insurance to protect itself from having to pay those costs; instead, the costs would be paid by an insurance company. Since [the dealership] will benefit from this coverage for more than 1 tax year, petitioner must capitalize the cost of the insurance."

Toyota Town, Inc. et al, TC Memo 2000-40, aff'd 268 F.3d 1156(9th Cir.) (2001):
Generally, the dealers must amortize insurance expenses; amortization begins when the contract is issued; the dealers cannot net the contract price and insurance costs. Should the dealers elect the SWIM method (Revenue Procedure 92-98) dealers must first comply with Revenue Procedure 92-97.

In summary, when a dealership acts as the obligor on an extended service contract and purchase insurance to cover its risk, it must include in income the full sales price of an extended service plan at the time of sale, and is allowed to deduct the insurance premium ratably over the term of the plan.

Service Warranty Income Method (SWIM)
In general, payments received by an accrual method taxpayer for services to be performed in the future must be included in gross income in the taxable year of receipt. The Service recognized that this treatment resulted in a significant and unique cash flow problem for dealerships that sell extended service contracts to customers in connection with the sale of motor vehicles and immediately pay a third-party to insure their risks under the contracts.

To remedy this situation, the Service made an administrative decision to permit these dealerships to adopt or change to a special method of accounting for advance payments that would alleviate the cash flow problem but would generally conform economically to the tax treatment of advance payments under current law.

Rev. Proc. 97-38, previously 92-98, provides for an alternative reporting method, the "Service Warranty Income Method" (SWIM). Taxpayers who elect SWIM may spread a portion of the service warranty contract income over the life of the contract. The amount of income that can be deferred is equal to the amount that is paid by the taxpayer to an unrelated third party to insure the taxpayer's obligations under their contracts. The amount qualifying for deferral is called the "Qualified Advance Payment Amount."

The SWIM method only applies when insurance is purchased from an unrelated party.  Dealerships that elect to defer the qualified advance payment amount must increase the income to be reported by adding on an imputed income amount on a level basis over the shorter of the actual term of the service warranty contract or a 6 taxable-year period.  

In addition to automobile dealers, manufacturers and wholesalers may use SWIM for fixed-term service contracts on motor vehicles or other durable consumers goods purchased by a customer with a separately stated amount for the service warranty contract if the taxpayer purchases insurance from an unrelated third party and makes payment to the insurer within 60 days after the receipt of the advance payment for the insurance costs associated with the policy.

In general, this method of accounting permits these taxpayers to recognize and include in gross income, generally over the period of the extended service contracts, a series of equal payments, the present value of which equals the portion of the advance payment qualifying for deferral.

The Service Warranty Income Method (SWIM) was originally implemented in Rev. Proc. 92-98 (superceded by Rev. Proc. 97-38.) For complete information on the implementation of the Service Warranty Income Method please see the revenue procedures.
    Rev. Proc. 97-38 Example

Facts:
    5 Contracts Sold January      1, 2000, @ $1,600 = $8,000
    5 Contracts Sold December 1, 2000, @ $1,600 = $8,000
    Total                                                                    $16,000

Dealership pays w/in 60 days of receipt of each advance payment, *$1200 per contract to an unrelated third party to insure (in an arrangement that constitutes insurance)

    Term - 5 Years
*Insurance Premium                                             $ 1,200 each
    AFR 10 percent

Qualified Advance Payment Amount [2] $12,000 x .2398 = $2,878 [1]

Non Deferred Income $ 4,000 [3]

[1] From tables found in Rev. Proc. 97-38 based on term of years (5) and the AFR
         (10%). (10 contracts x 1200=12,000)
[2] Definition of terms used in this example can be found in Rev. Proc. 97-38.

    [3] Non Deferred Income: $16000 ¡V 12000 = $4000

Total contracts sold less Qualified Advance Payment Amount = Non Deferred Income

   2000 2001 2002 2003 2004 2005

Non Deferred Income

$4,000                     

Deferred Income

$2,878 $2,878 $2,878 $2,878 $2,878

   

 

$6,878 $2,878 $2,878 $2,878 $2,878

   

Amortization

(1,300) (2,400) (2,400) (2,400) (2,400) (1,100)

Taxable Income

$5,578  $478  $478  $478  $478 (1,100)

Total (5578 +478+478+478+478-1100= 6390)        $6,390

 

Non Deferred                                          

4,000        

Additional Income                                 

$2,390   [4]

[4] This additional income is based on the add on AFR interest. This is the cost to the taxpayer for deferral of income and use of the Government's money during this time.

Court Cases:
Toyota Town, Inc, et al, TC Memo 2000-40, affd. 268 F.23d 1156 (9th Cir.) (2001): a consolidated case of several dealers who elected the SWIM method. The tax court held that the dealers must amortize insurance expenses. The amortization begins when the contract is issued. The dealers cannot net the contract price and the insurance costs. The 9th circuit affirmed the tax court decision and held that the dealers must comply with the method of accounting for the related insurance expenses prescribed in Rev. Procedure 92-97 as a condition of adopting the SWIM method.

Rameau Johnson et al v. Commissioner, 108 T.C. 448 (1997) aff'd in part, rev'g in part, 184 F.3d 786 (8th Cir. 1999): a decision about dealer's use of escrow or trust accounts in connection with their service contracts. The court determined that the sales price of the contract is income when received. The claims are deductible when paid and administrator fees are amortized over the life of the contract. The stop loss insurance costs must be amortized. The interest income is investment income to the taxpayer (dealer) when earned.

Contract Construction
Generally, a dealership is aware when it is a principal on a service contract. Most contracts explicitly state the dealer is a principal or an obligor. Some dealers may claim they are not principals, even though the contract explicitly states they are.

The courts have followed the IRS's interpretation of these contracts determining the dealer a principal, where the facts warrant. They have held that the IRS may consider evidence outside a written contract (parol evidence) if the terms of an agreement are unclear or ambiguous. The court determined in, Rochester Development Corporation v. Commissioner, T.C. Memo. 1977-307, CCH 34,630(M), the IRS may consider the surrounding circumstances and oral testimony of a transaction if the contract's terms of an agreement are not clear. See Commissioner v. Danielson, 378 F.2d 771 (3rd Cir. 1967) cert. denied, 389 U.S. 858 (1967), Joan S. Schatten v. United States, 746 F.2d 319 (6th Cir. 1984), and Johnie Vaden Elrod v. Commissioner, 87 T.C. 1046 (1986). 

However, parol evidence will not be allowed where there is no such ambiguity and the terms are clear. Where the contract is unambiguous, the courts have indicated they will narrowly construe the terms of the contract and uphold its clear meaning. For a taxpayer to challenge the Commissioner's construction of an agreement's clear and unambiguous form, some federal circuit courts have held the taxpayer must show proof that the agreement was unenforceable because of mistake, undue influence, fraud, or duress. See Rochester Development Corporation v. Commissioner, T.C. Memo. 1977-307, CCH 34,630(M).

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Change in Accounting Method Concerns and IRC section 481(a)

Treas. Reg. section 1.446-1(a) defines method of accounting as not only the overall method of accounting of the taxpayer, but also the accounting treatment of any item. A method of accounting is established by the proper treatment of an item in the first year that the taxpayer has the item or by improper treatment of the item in the first 2 years that the taxpayer has the item. A material item is one involving the timing of its inclusion or deduction. A change in method does not include correction of mathematical or posting errors or tax computation errors or of an item not involving a question of timing.

Treas. Reg. section 1.446-1(e)(2)(ii), states that a material item is any item which involves the proper time for the inclusion of the item in income or the taking of a deduction. A method of accounting involves the consistent treatment of a material item.  A material item is any item that involves the proper time for the inclusion of an item in income or the taking of a deduction (Treas. Reg. section 1.446-1(e)(2)(ii) and Rev. Proc. 91-31, 1991-1 C.B. 566). Rev. Proc. 97-27 provides a definition of "method of accounting." It states: "...the relevant question is generally whether the practice permanently changes the amount of taxable income..." Consistent treatment is established by using an improper method for 2 or more tax years (Rev. Proc. 97-27 and Rev. Rul. 90-38, 1990-1 C.B. 57) and a proper method for 1 year (Treas. Reg. section 1.446-1(e)(1)).

Under the method of accounting employed by some dealerships, only a "net" amount of the retail sale price of a dealer obligor mechanical breakdown contract is reported in the taxable year of the sale of the contract. This "net" represents the amount by which the sales price exceeds the insurance and administrative expenses. This method results in the exclusion from income, or early deduction of, expense items that properly should either be amortized over the life of the mechanical breakdown contract, or be deducted as economic performance occurs.

Requiring the dealer to change from expensing insurance premiums to amortizing them is a change in accounting method. This change affects the timing of the deduction of a material item.

A new dealership filing its first return has not established an accounting method where it erroneously deducted in its first year of operation, the entire premium for a multi-year period.

Under IRC section 481(a), when computing taxable income for any taxable year, "...(1) if such computation is under a method of accounting different from the method under which the taxpayer's taxable income for the preceding year was computed then (2) there shall be taken into account those adjustments which are determined to be necessary solely by reason of the change in order to prevent amounts from being duplicated or omitted..."

Treas. Reg. section 1.481-1(a)(1) provides that a change in method of accounting to which IRC section 481 applies includes a change in the over-all method of accounting for gross income or deductions, or a change in the treatment of a material item.

IRC section 481(b) provides for a limitation on tax where the change in method of accounting is substantial. This section allows for a computation of tax over 3 years if the method of accounting changed was used in 2 preceding tax years and the increase to taxable income for the year of change exceeds $3,000.

When adjustments are made under IRC section 481(a), the statute of limitations is not an issue. IRC section 481 provides that taxable income for the year of change must be computed by taking into account all adjustments necessary to prevent items from being duplicated or omitted. This includes amounts that would otherwise be barred by the statute of limitations. Graff Chevrolet Company v. Ellis Campbell, Jr., 343 F.2d 568 (5th Cir. 1965).
A second adjustment under IRC section 446(b) accounts for the difference in taxable income determined under the new method of accounting for the year of change as compared to the old method.

Rev. Proc. 97-27 provides the administrative procedures applicable to changes in methods of accounting. It applies a gradation of incentives to encourage voluntary compliance with proper tax accounting principles, and to discourage taxpayers from delaying the filing of applications for permission to change an improper accounting method.

Service Contract Overpayment Programs
The sale of vehicle service contracts (VSC) continues to be a popular source of additional income for automobile dealerships. Vehicle service contracts are available in a variety of formats, with an assortment of options, and may name the dealership or another party as the obligor. Due to the varied programs available, the proper tax treatment can be complicated. This section is intended to address only one aspect of some service contract programs, i.e. the possible diversion of income using an "overpayment" agreement. It is not intended to clarify all issues related to VSC or to be inclusive of all areas of potential non-compliance.1

The VSC option described in this section (diversion of income from the dealership and non-reporting of the income by the recipient) presents an opportunity for confusion, inconsistent tax treatment, and possible widespread non-compliance. The Motor Vehicle Technical Advisor (MVTA) is evaluating this issue to determine the scope of the noncompliance.

This section is the first step in a program to provide guidance to IRS and industry personnel of the proper treatment of the issues and the possible effects of noncompliance.

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Overview of the Issue
The programs may vary slightly in operation; they can be identified by various names such as "over submits, dealer override agreements, over remit programs, or management contracts " and are found in non-dealer obligor programs and dealer obligor programs for new and used vehicles.

Example
Facts

In conjunction with the sale of a vehicle, the dealership also sells the customer a vehicle service contract. The price of the vehicle service contract is $800. The dealership is required to pay the obligor/administrator $400 under the contract. 

No "over payment arrangement"
The dealership retains $400 as commission (retention amounts will vary by program) and submits the remaining $400 to the obligor/administrator. 2 Assuming that the program is a pure dealer agent program, the dealership reports $400 as income.3  Generally, there is no unreported income issue.

"Over payment" arrangement in place

The dealer executes a voluntary supplemental agreement to pay to the obligor/administrator an amount in excess of the contractually required amount. For example, rather than retaining $400 and submitting $400 as in the example above, the dealer may submit $550 to the administrator and retain only $250.

The supplemental agreement between the dealership and the obligor/administrator allows the dealership to determine the amount of the overpayment and to designate a "beneficiary" to receive the overpayment amount. The designated "beneficiary" may be an individual, e.g. the dealership shareholder, spouse, child, etc., a corporation, e.g. the dealership, a related corporation, or another entity e.g. reinsurance company or a related S corporation.

The supplemental agreement may require the inclusion of the beneficiary's Federal Tax Identification number or Social Security number and the obligor/administrator may issue Forms 1099 if the beneficiary is an individual, partnership, or sole proprietor. If the beneficiary is a corporation, a Form 1099 is not required. On a periodic basis, generally monthly, the obligor/administrator aggregates the over submitted amounts and remits the total amount to the beneficiary.

By reducing the amount retained by the dealership from $400 to $250, the overpayment effectively reduces the income reported by the dealership by the $150 over submitted amount. The $150 over submitted amount might be reported as income by the "beneficiary," however if no Form 1099 is filed, there is no tracking of the beneficiary.  Even if the beneficiary reports the income, the overpayment amount represents income to the dealership.

Discussion
There are many reasons, in addition to reducing reported income why a dealership might execute an over payment agreement. According to some industry sources, reducing the profit on the sale of a vehicle service contract reduces the base amount on which the Finance and Insurance Manager's sales commission is based. The over payment programs also allow an individual to redirect capital to another entity that enjoys a more favorable tax treatment. Regardless of why a dealership engages in the over payment program, it is vital that the program be treated properly for tax purposes.

Preliminary analysis indicates that the proper reporting of vehicle service contract overpayment amounts rests on the definition of gross income and the principle of assignment of income. By making an overpayment to the obligor/administrator and designating a ¡§beneficiary¡¦ to receive the over payment amount, the dealership assigns income to the beneficiary.

IRC §61 defines gross income as income from whatever source including compensation for services such as fees and commissions. Dealerships earn income on the sale of vehicle service contracts. Ordinarily, the difference between the selling price of the vehicle service contracts and related expenses represents income to the dealership. When a dealership makes a payment to the obligor/administrator in excess of the amount ordinarily required, the dealership artificially reduces the income reported on the sale of the service contract.

The controlling principles regarding assignment of income issues are found in Lucas vs. Earl, 281 U. S. 111 (1930). Generally, the question is whether a taxpayer is responsible for the tax on an amount or whether some other person or entity that receives the amount at the direction of the taxpayer should pay the tax on the item. The Court ruled that the "...fruit must be hung on the tree from whence it came..." and that the taxpayer that directed the payment of the amount to another party is responsible for the appropriate income tax on that amount.

Overpayments made to the VSC obligor/administrator represent income earned by the dealership and assigned to the beneficiary. Lucas vs. Earl, supra, requires income to be allocated to the dealership that earned the income. Depending upon the relationship of the beneficiary to the dealership owner, the overpayment may be characterized as a non-deductible dividend to the dealership owner or in some other fashion.

  1. Issue:

    1. Is the overpayment amount income to the ultimate recipient (dealer/obligor/shareholder/owner)?

    2. Is the overpayment a deductible expense?

    3. Is the overpayment a dividend?
       

  2. Documents Needed

    1. Request a listing of all VSC/maintenance plans sold b the dealership during the year(s) under examination.

      1. Request a listing of all Dealer over submit, Dealer Override, Dealer Remit or Management Programs

        1. Request copies of all voluntary supplemental agreement to pay an administrator a fee in addition of the contractually required amount

      2. For each program sold, request the following information:

        1. Copies of actual, executed vehicle service contracts

        2. Copies of any promotional material

        3. Copies of any and all agreements and documents including all endorsements, amendments, and schedules between the dealership and other parties to the program.

          • Documents may include but are not limited to: dealer agreements(s), administrator agreements(s), contractual liability insurance policy, service contract reimbursement insurance policy, consulting agreement(s), management agreements(s), reinsurance agreements(s), and warehouse agreements(s)

        4. Request that the dealership provide, in writing, all accounting entries for all income and expenses.

      3. Request a written statement from the owner of the dealership concerning:

        • Payments made by any party to the program, directly or indirectly, to the dealership owner, any relative of the owner, or entity owned (all or in part) or controlled by the owner.

      4. Do not be afraid to ask questions about the dealership's programs. Do not limit questions to the dealer's representative, controller, or employees.

        • The dealer principal may be the only one fully informed regarding the details of the programs.
           

  3. Audit Techniques

    1. Determine by review of the vehicle service contract language whether the VSC is dealer obligor or dealer agent.

      1. Generally, dealer obligor contracts state that the VSC is a contract between the vehicle purchaser and the dealership.

      2. Dealer obligor contracts contain a provision naming an administrator and/or insurer and may contain terms similar to the following:

        • The agreement is not an insurance policy.

          • The dealer is financially responsible for all repairs under the VSC.

        • The dealer's obligations under the contract are insured by "Insurance Company"

        • The administrator is not obligated under the contract.

    2. For dealer obligor contracts:

      1. Analyze the administrator agreement to determine the dealership and administrator's responsibilities under the program. (Note: Some dealerships participate in multiple programs that apply to the same VSC. For instance, one program provides basic program administration and claims handling while a second program simultaneously provides for the establishment of the dealership's PORC. As a result, the dealership may have multiple administrative agreements, insurance policies, etc. To determine the proper tax treatment on the sale of the VSC, the entire transaction must be analyzed.)

        • The administrator agreement may include a provision for a reserve or escrow account, the establishment of a PORC, payment of various fees to parties related to the dealership or administrator, etc.

      2. Review amendments, endorsements, and schedules for clues to other agreements, payments to related parties, etc.

      3. Analyze the insurance policy to determine the coverage and to determine the "name insured".

        • Generally, dealer obligor programs provide for a contractual liability policy naming the dealership as the insured.

        • Determine if there is any common ownership between the dealership and the insurance company.

        • Determine if the dealership or other party related to the dealership provides indemnification to the insurance company.

        • If the dealership purchased insurance from an unrelated insurance company and did not enter into a reinsurance agreement, determine if the selling price of the contract is included in the income in the year the contract is sold.

          • Determine if the cost of insurance was amortized over the contract life.

          • Determine if the dealership properly elected and applied the Service Warranty Income Method (SWIM) of reporting income.

          • Determine how the dealership accounted for administration fees.

      4. Analyze the supplemental agreement between the dealership and the obligor/administrator to determine the amount of the overpayment and to designate a ¡§beneficiary¡¨ to receive the overpayment amount.

        • The designated beneficiary may be an individual, (dealership/shareholder, spouse, child; corporation/dealership; related corporation, or another entity, i.e. reinsurance company or a related S corporation.

        • The agreement may require the inclusion of the beneficiary's Federal Tax Identification Number or Social Security number and the obligor may issue Forms 1099 if the beneficiary is an individual, partnership or sole proprietor.

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Conclusion
The overpayment program is just one option in the variety of vehicle service contract programs that are available. The lack of uniformity in the overpayment programs makes it difficult to formulate a "one size fits all" approach to the proper tax treatment.

Definitions
Administrator: -
An administrator is usually an unrelated party. They are responsible for administering service contracts for the dealership

Agent: - If the dealer is an agent of the administrator, insurer, or other party, the contract will contain language that indicates that the contract is between the vehicle purchaser and the other party, not the dealership. The contract administrator is also named in the contract.

"Principal" / "Obligor": - If the dealer is the principal, the contract will contain provisions indicating that the contract is between the dealer and the vehicle purchaser.

Vehicle Service Contract: - (VSC) also known as an extended service contract primarily for vehicles, new or used.

Administrator Agreement: - An agreement between the dealership and administrator's responsibilities provided to the extended service contract program. (Note: Some dealerships participate in multiple programs that apply to the same VSC. For instance, one program provides basic program administration and claims handling while a second program simultaneously provides for the establishment of the dealership's PORC. As a result, the dealership may have multiple administrative agreements, insurance policies, etc.)

Service Warranty Income Method (SWIM): - An election under Revenue Procedure 97-38, previously 92-98, which provides for an alternative Income reporting method, the "Service Warranty Income Method" (SWIM).  Taxpayers who elect SWIM may spread a portion of the service warranty contract income over the life of the contract. The amount of income that can be deferred is equal to the amount that is paid by the taxpayer to an unrelated third party to insure the taxpayer's obligations under their contracts. The amount qualifying for deferral is called the "Qualified Advance Payment Amount." The SWIM method only applies when insurance is purchased from an unrelated party. 

Service Contract Overpayment Programs: - Also known as Dealer over-submit, Dealer Override, Dealer Remit or Management Programs. This is a supplemental program that may be included in the vehicle service contract. This calls for a voluntary supplemental agreement to pay an administrator a fee in addition of the contractually required amount.

VSC Audit Technique Flow Chart

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__________FOOTNOTES__________

  1. Proper tax treatment of the transaction will vary depending upon the specifics of the VSC program. Any potential tax issues related to other aspects of the transactions are not the subject of this section.

  2. Depending upon the program, the amount submitted to the obligor/administrator may be used to purchase insurance, be placed into a trust or escrow account, or be used for other purposes. 

  3. The tax treatment will vary significantly if the program is a dealer obligor program or contains other features such as  escrow or trust accounts.

Chapter 6 | Table of Contents | Chapter 8

Page Last Reviewed or Updated: 27-Nov-2013